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MSCI China A-share inclusion along the way of China’s transition to quality growth

In June 2017, MSCI announced the partial inclusion of China’s domestically traded, yuan-denominated stocks, or so-called A-shares to MSCI China, MSCI Emerging Markets (EM), and MSCI All Country indices, which is to be implemented from June 2018.

A-share inclusion was previously rejected in any indices due to limited market accessibility to global investors and restrictions on repatriation of capital, among others things. Then, the Chinese authority addressed these issues gradually, in particular by launching the Stock Connect schemes1.

At 5% inclusion factor,2China A-Shares will account for roughly 0.8% of the MSCI EM Index, 1.1% of the MSCI Asia Index, and 0.1% of the MSCI AC World Index. The inclusion of China A-shares this year will take effect through a two-step process of 2.5% each, effective on June 1, 2018 and September 3, 2018.

While inclusion has symbolic significance, there should be limited financial implications for other Emerging Markets, at least in the short-term.

We are looking at the opportunities that the A-share market presents, with a clear preference for sticking to strict valuation criteria and good corporate governance. However, A-shares trade at a large premium over H-shares, so we currently prefer the latter in the Chinese market.

The opening-up of China’s financial markets is among the China’s efforts in domestic reforms to facilitate structural transition towards a quality growth model, and intends to further improve its role on the global stage. We can see this happening in a broad range of areas. In particular, China has made progress over the past years in pushing the internationalisation of its currency, with the result that the Renminbi (RMB) has been gradually recognised as a reserve and payment currency. To make the RMB eventually emerge as a leading international currency will need time, and depends on further reforms.

China’s reform efforts are expected to continue, as they are what China needs for generating sustainable, high-quality growth (more focused on domestic demand and higher value added economic sectors). Despite the slowdown of credit growth, the Chinese economy has been relatively resilient. China debt remains a cause for concern but we may have seen the peak in debt growth with ongoing structural transition.

The inclusion of Chinese A-share in MSCI’s indexes will help to pave the way for foreign capital inflows into China’s financial markets.

How could MSCI China A-share inclusion affect global investments?

Tricot-Tsui: The inclusion of Chinese A-shares in MSCI’s indices is symbolic of China’s increased financial markets liberalization and is set to help attract foreign investors. Passive funds will be forced to buy the A-shares to minimize tracking error3, while active managers may target China’s domestic market as, from a valuation perspective, it offers stocks with relatively low prices compared to their international peers.

MSCI China A-share inclusion should nothave significant implications for other Emerging Markets in terms of capital outflows, at least in the short term.

What could be the main financial impact on other emerging markets and sectors?

Tricot-Tsui: Overall, there should be limited financial implications for other Emerging Markets, at least in the short term. Korea stands to be the biggest loser from the inclusion, with estimated outflows of $1.2bn, followed by Taiwan at $920m, and India at $584m (that is ca. 20bp drop in weighting in the MSCI EM Index). Among industrial sectors, technology would be the hardest hit, with estimated gross outflows of $2.4bn (or net outflows of US$1.5bn), that is 40% of the inflows will be funded by selling in technology. Roughly $1.5bn of selling (or 25% of the total outflow) will be in the biggest four names in the EM index, namely, Tencent, Alibaba, Samsung Electronics, and TSMC.

Chinese H-share still represents the biggest opportunities in the EM equity space. We also look at opportunities in A-share market but with a strong focus on risks.

Where do you see the most attractive EM equity opportunities in the next few months?

Tricot-Tsui: We currently see Chinese H-shares as the biggest opportunities in the EM equity universe. Although China growth has come down, its financial risk has declined significantly in recent times, especially following the new regulations. Signs of improving gearing and pay-out ratio coupled with stricter investment criteria may also lead to more potential returns to shareholders. Overall, we think investors should expect lower growth in China, but with better stock market returns, which could fare positively versus the past (characterized by higher growth but disappointing markets).

We also see sizeable investment opportunities in the A-share market, but significant risks still exist with the standards not in line with other Emerging Markets. Two examples are worth mentioning. First, around 8% of Chinese stocks are still suspended and cannot be traded: this percentage is much higher than it has been anywhere else with unclear rules. Second, there is a sizeable portion owned by what is called “the national team”, basically public institutions, which intervened in 2015 to stabilize the market and whose interests may not be

fully aligned with those of the foreign shareholders. Finally, given the dominance of retail investors in the market, A-shares trade at a large premium over H-shares.

So overall, the A-share market poses a considerable investment risk but, nonetheless, presents opportunities which we are looking at, with a clear preference for sticking to strict valuation criteria and good corporate governance.

China needs to adopt further domestic reforms to facilitate the structural transition towards a quality growth model and strengthen its global role.

What are the next steps for China to reinforce its global role?

Wang: China’s MSCI inclusion in the MSCI benchmark indices is a landmark in China’s financial reform and liberalisation, but the country needs to ratify further reforms for its role to further grow on the global stage. With China’s economy widely expected to be slowing, the Chinese efforts need to continue to be allocated in domestic reforms aimed to facilitate the structural transition towards a quality growth model. Along with such efforts, more financial openings could be pushed further ahead, to meaningfully improve China’s financial role. As of now, this is happening in a broad range of areas, with more efforts likely to come: in addition to the aforementioned equity inclusion in the MSCI indices, China has been pushing for the inclusion of onshore bonds in the major global benchmark indices (already, an announcement was made to include it in the Bloomberg Barclays Global Aggregate Index from Q2 2019); more active overseas investments in the infrastructure with the promotion of the One Belt One Road (OBOR) initiative; in the forex market the Renminbi’s (RMB) internationalization has been a long term target; meanwhile, since late last year, China committed to further open up its domestic financial sectors to foreign investors in the coming years.

The effects could become more visible, with China’s OBOR projects to more meaningfully affect many emerging markets by providing additional sources of funding; Chinese assets are to catch up significantly in global investors’ portfolio and Chinese savers are to be allowed to more easily invest in overseas markets as important clients to global funds; People’s Bank of China (PBoC)’s policy decisions are to become more independent drivers to global investors; and RMB could gradually be recognized as a leading reserve and payment currency, particularly in Asia and emerging markets.

Overall, if policy efforts continue in the right direction, they could help China to have a much stronger impact on global financial markets and become a key stabilizer in emerging markets, and to help EMs to become more integrated and self-driven, less dependent on developed markets, both economically and financially.

RMB internationalisation could resume its momentum, helped by benchmark inclusion of local assets, after pausing in previous few years.

Do you think the Chinese Renminbi (RMB) may eventually become a leading global currency?

Wang: RMB internationalisation could resume its momentum, after pausing over the previous few years. China has made great efforts over the past decade to push the internationalisation of its currency. RMB inclusion in the Special Drawing Rights (SDR) basket in October 2016, in particular, was an important pillar in favouring the international use and trading of RMB. As was the Belt and Road Initiative, which has further encouraged the global adoption of the yuan. That said, the momentum has been on pause since 2015 due to strong fears of a RMB devaluation and capital outflows. With capital outflows under control since last year while RMB remained resilient, RMB internationalisation looks to be resuming momentum. While inclusion of onshore equity and bonds into major benchmark indices could facilitate the process, Chinese policymakers are also making new efforts. More recently, the launch of the yuan-denominated oil futures appears to be partially replacing the dollar in the commodity space.

Already, the European Central Bank in 2017 and the German Bundesbank in 2018 added the Chinese currency into their foreign-exchange reserves. We expect more reserve managers to adjust their holdings by increasing their exposure to RMB assets.

Although the RMB is to be increasingly used for global transaction and financing by financial institutions, data from a SWIFT RMB Tracker report showed that global payments using the yuan accounted for 1.62 percent of all transactions in March 2018, ranking 6th among the most-used currencies (it was 35th in 2010).

Looking forward, we expect China to continue its efforts to break the pegging of RMB to USD, towards more market-driven and a more flexible regime.

China’s reforms efforts are set to continue or even to accelerate. As a result, ongoing structural transition will make debt less of a concern, together with the policymakers’ determination in deleveraging and efforts in reforming its regulation system.

What structural reforms are on the way, in particular to make debt less of a concern?

Wang: Growth drivers are now more broadly-based, with clearer evidence that economic structure is shifting towards more efficient and less debt-dependent sectors (more focus on service and higher valued added industry).We believe that for China’s economy to be resilient and less risky, generating sustainable, high-quality growth, China’s reforms efforts have to continue in the right direction while avoiding unnecessary mistakes. Regarding this, there have been increasing signs of policymakers to speed up reforms to celebrate the 40th anniversary of Reforms and Opening-up (1978-2018).

In addition, US-China talks have served to accelerate certain reforms. During his Boao speech in early April, President Xi Jinping committed to the following measures, which are in the process of being delivered:

To further open up of financial and services sectors.

To encourage imports, including a cut in import tariffs. Cutting import tariffs on vehicles and car parts, announced to start from July, will help the advance of supply-side structural reform. Cuts in import tariffs is being extended to a group of consumer products.

To reduce barriers for a more business-friendly environment for foreign investors.

To strengthen intellectual property rights protection.

As a result, we expect China’s overall debt to become less of a concern. It has become more visible that continued reforms are facilitating a structural shift in the economy towards less debt dependence and more efficient sectors. Meanwhile, policymakers seem to have strong determination in deleveraging and reforming its domestic financial system. More discipline is added to local government budget management and financing, while the government is also attempting to better match local responsibility with fiscal capacity.

Significant efforts have been also made by Chinese authorities in tackling shadow banking, by catching up with regulation with system becoming more coordinated following comprehensive restructuring.

[1]
A collaboration between the Hong Kong, Shanghai and Shenzhen Stock Exchanges, Stock Connect allows international and Mainland Chinese investors to trade securities in each other's markets through the trading and clearing facilities of their home exchange.

[2]
Large Cap China A shares will be added to the MSCI China Index, the MSCI Emerging Markets Index and the MSCI ACWI Index at 5% of their Foreign Inclusion Factor (FIF)-adjusted market capitalization through the application of a Partial Inclusion Factor.

[3]
A measure of how closely a portfolio follows the index to which it is benchmarked.

With the contribution of:Giovanni LiccardoInvestment Insights Unit

TRICOT, CFA Mickaël , Deputy Head, Emerging Market Equities

Tsui Gwendolen , Senior Portfolio Manager

WANG Qinwei , Senior Economist

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MSCI China A-share inclusion along the way of China’s transition to quality growth